Of fiscal multipliers and Pandora’s boxes

An Admission and Pandora’s Box

Earlier this month, the head of the International Monetary Fund (IMF), Christine Lagarde, called for looser deficit reduction deadlines for Greece and issued a cautionary note regarding the relentless pursuit of ‘austerity’ policies. However, what will prove to be the historically most important point she made was with reference to “fiscal multipliers”. This was the admission that many governments, economic forecasters and, indeed, the IMF itself, had underestimated the true repercussions of government spending cutbacks on economic output.


What are these “fiscal multipliers”?

Just by how much does austerity hurt our economies?

What are the long-term ramifications of the multiplier fiasco?

These are questions that I will address and I will propose that austerity may well open a Pandora’s Box.

We will turn to the first question. The IMF’s World Economic Outlook suggested that the “fiscal multipliers” governments have used to estimate the economic effects of their spending cutbacks had been too weak. Or, put another way, just too plain optimistic. Or, too plain simplistic. Or, too theoretical. Original estimates undertaken by the Office for Budget Responsibility in the UK used a “fiscal multiplier” of 0.5, meaning that every for £1 in spending knocked off government expenditure 50pence was knocked off Britain’s Gross Domestic Product. This too was the generally accepted ‘rule of thumb’ observed by the IMF and relied upon (presumably) by national leaders championing austerity. Based upon evidence from research conducted across 28 countries, the IMF revised this estimate stating that the real “fiscal multiplier” is more likely to be somewhere in the region of 0.9-1.7.

Such estimates are not only worrying but staggering. Could it really be true that by cutting £1 of government expenditure our economy could be reduced by as much as 170% of that sum and not a mere 50%?

The answer, sadly, is yes. Princeton Economist Paul Krugman notes that austerity driven policies are largely counter-intuitive and have significant knock-on effects. He states that austerity programmes hurt economic output, then leading to private sector cut backs and layoffs. The reality is, that in a world where there are increasing numbers of people outside of full-time work, there are likely to be more claims for government aid such as job seeker’s allowance. Less people in jobs will mean that economic output continues a downward spiral and more people having to claim benefits to help them get by means the government will have to spend more. In this respect we can see two things: 1) Austerity hurts growth and leads to unemployment and 2) Due to this unemployment, more people will have to claim aid from the government, undermining its original attempts to save money.

A Simplification?

But there is another angle to look at this from. By assuming a single ‘standard’ multiplier, the economists (and others) supporting austerity strategies seem to assume that human behaviour runs in a straight line. In behavioural terms, we will react to increases and reductions in government expenditure in exactly the same way. Also, this approach ignores the context or the environment within which expenditure decisions are made. In confident, buoyant times, human reactions to changes in government spending will be the same as reactions in the worst of times. Looking at Box 1.1 of the above report we can see that the 0.5 multiplier was arrived at by looking at the period 1989 – 2009. This period does not reflect the specific and unusual context that we now find ourselves in. We are in the midst of a financial crisis second only to the Great Depression of the 1930s. The assumption therefore that one multiplier applies in all situations is alarming. The reality, I would propose, is that there are a set of non-linear behavioural curves (not one simple multiplier) that reflect reactions to adjustments in governments’ spending adjustments that are highly contextually specific. It therefore comes as no surprise that reductions in government expenditure in the worst of times produces a doom spiral of confidence taking us towards the 1.7 (or beyond) multiplier effect. It is of interest too that concerns about multipliers were aired about 10 years ago.

But I am not an economist just a behaviouralist so not doubt I will face a concerted attack!

Pandora’s Box

And so this leads me to my last point. Currently, youth unemployment levels in Europe are really worrying. In Greece, youth unemployment stands at 55.4% and in Spain 52.9%. In the Euro area there are some 3.4 million young people without work. To get that in perspective, the population of one EU state, Ireland, is 4.5 million. In the EU-27 area we have 25.5 million people unemployed. In early 2001 the figure was approximately 19 million and from 2009 to the end of 2011 youth unemployment rates in Greece have spiralled from 25.7% to 44.4%. How long, under a regime of austerity, will it take for these unemployment levels to reduce to socially acceptable levels? 10 years? 15 years 20 years? And who will influence these young minds along this protracted road to recovery?

But the biggest question must be:

Would we have embarked upon the road of austerity if we knew the true fiscal multipliers?

The answer may be ‘no’.

But the real worrying issue is that we may have unlocked Pandora’s  Box and that austerity may be the final self-inflicted blow that destroys the Washington Consensus.


With thanks to Henry Davies for underlying research

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